RBI, currency depreciation give sleepless nights to FIIs

Foreign Institutional Investors (FIIs) are a worried lot these days. So far they’ve had to carry equity risk, but now there’s also a currency risk to deal with as well. The recent volatility in the rupee has eroded the value of their over $100 billion equity investments in India since 2009. On the debt side, higher hedging costs have rendered debt investments unviable. To make matters worse, the Reserve Bank of India’s been sending out confusing signals on interest rates by announcing bond sales one day and buyback another. Though the Indian rupee has appreciated in the last fortnight, currency strategists say that the 28 per cent fall in the rupee between 30 April and 28 August is the worst kind of volatility the rupee has seen in several decades and this has really hurt foreign investments.

In order to get a fix on the Indian markets and plan their strategy ahead, FIIs are talking to CEOs, strategists and regulators to get a handle on what is to be expected. Keki Mistry, vice chairman and CEO of HDFC Limited says in a day he speaks to three FIIs on the prevailing macro-economic situation in the country and what is RBI likely to do on 20th September. According to Mistry: “One real concern that FIIs have is how long would RBI continue with their liquidity tightening measures. The other concern is political and how long the uncertainty will continue.” The RBI’s tightening is putting pressure on the banking system as higher rates would only increase the stress of bad assets. With projects not getting the relevant clearances on time, companies across the spectrum -- small, mid and even large -- are unable to complete their projects on time. Consequently, their interest expenses are rising fast thereby affecting their earnings, cash flows and ability to repay loans. These are real concerns as some serious FII money has gone into banking stocks.

Macquarie Capital has met nearly 40 foreign investors in Asia since the beginning of September and most of them remained cautious on Indian equities, and they believe that financials would be a tough place to make money over the next 12 months. Though large long-only funds continue to remain in large stocks, these investors are visibly frustrated and are not looking to sell at current levels. This frustration stems from the diminishing dollar returns. In rupee terms, the performance of stocks in consumers, banking and pharma look attractive, but the dollar returns of these stocks are abysmal. Kotak Institutional Equities, says Asian Paints’ 17 per cent annualised return from January 1, 2011, in rupee gets diluted to a paltry three per cent dollar return and even ITC’s stellar 27 per cent annualised return in rupee morphs into a passable 11.5 per cent dollar return. If foreigners have to continue investing in India, they should ideally seek higher required rate of return to offset the negative impact of rupee depreciation in order to get the ‘same’ ‘earlier’ dollar required rate of return, explains Kotak. The cost of capital is rising for foreign investors and they can no longer hope to make higher nominal returns from India.

Apart from the immediate concerns that impact their existing investments, FIIs also want to know how India would cope if crude oil prices rise significantly from current levels of $110-112 a barrel, which would put pressure on India’s current account deficit (CAD) and currency. India needs to recoup its forex reserves for an eventuality like this for sure. However, how much Raghuram Rajan’s swap facilities and other measures yield will be evident from end of November. Nevertheless, there are external factors on which the government and the RBI have little control, and that can play havoc with Indian markets and among the important ones (apart from crude oil prices) is US Fed tapering.

Indranil Sen Gupta of Bank of America Merrill Lynch expects RBI to persist with the July 15 tightening into December unless the Fed defers tapering on Wednesday. Keki Mistry believes that sentiments can turn quickly and if the Fed says that it is deferring its taper or announces a small tapering of $10 billion then markets will move up. On the other hand, if the Fed says that they will taper bond buying by $25 billion then markets will tank. A lot of this is sentiment driven.